NEW YORK – Like death and taxes, crises and bailouts are inevitable, and regulatory reform will not change that, so legislation should instead focus on limiting their magnitude by taxes on financial institutions, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said today.
“The Congress of the United States is currently considering legislation to restructure financial regulation. However, no matter how well-written or how well-intentioned the legislation may be, no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers—for the best of reasons—to bail out financial firms. In other words, no legislation can completely eliminate bailouts. Any new financial regulatory structure must keep this reality in mind, Kocherlakota told the Economic Club of Minnesota, according to prepared text of his speech, which was released by the Fed.
But he said, bailouts can be contained by taxing financial institutions. “Knowing bailouts are inevitable, financial institutions fail to internalize all the risks that their investment decisions impose on society. Economists would say that bailouts thereby create a risk `externality.’ There is nearly a century of economic thought about how to deal with externalities of various sorts—and the usual answer is through taxation. I will suggest that the logic that argues for taxation to deal with other externalities is exactly applicable in this case as well,” he said.
While others calling for taxing banks do so with revenge as a motive, Kocherlakota said, he believes that some big banks chose to “make socially undesirable choices” because of “incentives within the tax and regulatory system” that were based on expectations that in case of a crisis, there would be some bailouts. “Taxation is a useful way to correct this incentive,” he said.
While some observers emphasize the need for better resolution mechanisms, Kocherlakota said, “I do not believe that better resolution mechanisms will end bailouts. ... No matter what mechanisms we legislate now to impose losses on creditors, Congress, or some agency acting on Congress’ behalf, will block them when we next face a financial crisis. And Congress will do so for a very good reason: to forestall a run on the key players in the financial system.”
Financial firms make investments that are, by nature, risky and are financed by debt and deposits. “Now, imagine for a moment that we live in a world without bailouts, so that the government does not provide debt guarantees or deposit insurance. If a financial institution decided to increase the risk level of its investment portfolio, its debt holders and depositors would face a greater risk of loss,” he said. “By way of compensation for that greater risk, they’d demand a higher yield. As a result, in the absence of government guarantees, financial institutions would find it more costly to obtain debt financing for highly risky investments than for less risky ones. This effect, on the margin, would curb a firm’s appetite for risk. It would have an especially powerful effect on highly leveraged financial institutions, because high debt-to-asset levels mean higher risk of being unable to fulfill debt obligations.”
But, Kocherlakota said, he’d prefer a policy where firms know “the government will estimate the expected, discounted value of bailouts that the financial institution (or any of its stakeholders) will receive in the future.”
Based on a firm’s leverage ratio, the maturity structure of its liabilities, the risk characteristics of its investment portfolio, and its incentive compensation schemes, the government would charge “the firm a tax that is exactly equal to the expected discounted value of the firm’s bailouts.”
Returning to legislation, the Senate bill declares it will end taxpayer bailouts. “This objective is laudable. But it is not achievable – and thinking that it is can lead to poor choices about the structure of financial regulation,” Kocherlakota said.
